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Alternative investment assets, such as hedge funds, may offer several unique advantages to investors: freedom from most regulations, unconstrained choices of financial tools, unique return premia, and investment opportunities beyond the normal means. They also pose challenges for investors, such as high costs, illiquidity, and lack of transparency. During the past decade, hedge funds as an asset class lagged the general equity market significantly. With the compression of returns in recent years, investors have become more sensitive to overall fees. The desire to lower fees has led to a push for the development of liquid alternatives as viable alternatives to hedge funds. At its core, liquid alternatives seek to capture alternative beta returns that show a high correlation to hedge fund returns, and capture most of their benefits at a fraction of the cost. The objective of this article is to assess the performance of liquid alternative strategies built upon the systematic sale of equity index options and examine if they can offer the same benefits of hedge funds, such as superior risk-adjusted returns and low correlations with traditional portfolio holdings.
MOTIVATION OF USING OPTION STRATEGIES AS ALTERNATIVES TO HEDGE FUNDS
There is a growing array of hedge fund replication products available, almost all based on the linear factor replication approach developed by Hasanhodzic and Lo [2007]. This approach attempts to decompose hedge fund returns into factors tradable using a combination of liquid instruments, such as futures, swaps, and ETFs. However, there has also been a wide range of criticisms of this approach. The major problems include large tracking errors, poor returns, high correlations with the equity market, and slow response time. One hypothesis was that hedge fund returns tend to have non-linear components and linear factor models cannot easily emulate their return streams (Pochon and Teiletche [2006]). Researchers have proposed advanced approaches based on non-linear models to address the problem, and option-based strategies may be one solution to this conundrum (Jurek and Stafford [2015]).
Hedge fund replication products may have used a misguided approach from the beginning. When investors incorporate alternative assets into their portfolios, they seek several main attributes: superior risk-adjusted returns, mitigated risks (low volatility and small drawdowns), and diversification from traditional assets (equity or fixed income). The investors do not necessarily...